Friday, October 14, 2005

Closing the Barn Door

S.E.C. Accuses Hedge Fund of Deceiving Its Investors

So reads the headline in today’s New York Times, and so the Feds, arriving at the farm in Ketchum, Idaho, prepare to securely close the barn door after the horse has scampered out over the north forty, splashed across the Wood River and made its way to the freedom of the mountains beyond."There was no effective oversight of the investment manager and no effective control or checks on his [John Whittier, manager of Wood River Capital Management] actions," said Peter Bresnan, associate director in the enforcement division at the Securities and Exchange Commission.

As opposed to the effective oversight and effective control at, say, Refco—which had real auditors, unlike the fake ones employed by Wood River (identified by Whittier as “American Express Tax and Business Services” although that firm does not perform audits)—and real investment bankers and real SEC-filed documents detailing everything except what the CEO wanted the auditors and investment bankers and the SEC to find out.

Add Wood River to the list of hedge funds with the bucolic names (Bayou among them) and the hellish business model that no amount of supervision from above could prevent, given bad intent by the likes of John Whittier and Phillip Bennett, and the rest.

How forcing all hedge funds to register with the SEC—the very same entity that missed the massive alleged fraud at Refco and is now searching vainly for what caused the barn door at Wood River to be left wide open in the first place—is beyond me.

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations.

50 comments:

REFCO, one of the top 10 Brokerage houses that I've never heard of, is effectively gone, and, like it or not, kind of backs up what NCANS and Byrne and Sanity Check have been saying for a few months. That's an observation. The question is; How will this effect more well known brokerage houses, such as Morgan Stanley, or even TROWEPRICE? That's my $64 brazillian question for the day. Any comments?

It is a shame that the SEC is so gung-ho on the "deceiving investors" theory, that they seem to be missing the point on the "failing to file 13D and 13F" issues.

The investors KNEW they were getting involved with an unregulated investment partnership, and KNEW, or should have, that such vehicles carry very high risk and the managers are free to do pretty much whatever they wish. The only way they were deceived is by their own greed, and by the failure of Wood River to file timely 13F and 13D reports.

After seeing Scott Sacane's Durus corner the market on three biotechs a few years back, and Michael Lauer's Lancer corner a ton of worthless penny stocks before that, perhaps it was the SEC's lack of swift action in those cases that led to Wood River thinking it could do the same. Corner the market in ENWV and create a massive short squeeze.

Earlier this year Endwave (ENWV) was the bane of many short sellers, who could not understand its constant march upwards, until now. This is eerily reminiscent of Aksys (AKSY) in 2003.

Perhaps a simple answer to this problem of late or non-existent 13D/G/F filings is to switch the responsibilty to the Prime Brokers. Perhaps the Prime Brokers should have to notify the SEC in some way when an account crosses the 5% and 10% ownership thresholds.

And to rvac106, REFCO's problems have 0% to do with OSTK, Byrne, or the rest of the nutters.

Jeff,Your point is exquisitely on point, which may be the reason why it will be ignored by the general public and the political powers that be. The complete lack of logic involved with our modern regulatory system baffles me. Has America outgrown its infrastructure? I with there was a way to introduce competitive governance models just like we have competitive business models. Ours clearly has issues.

So I'm not clear as to what you propose: should the SEC continue to largely ignore the hedge fund world due to the fact that it couldn't stop Bennett from fraud and thus will be unable to decrease the amount of fraud/public pain created by the non-regulated world of hedge funds?

IMO, the fact that the SEC has not prevented several infamous blowups from occuring is not proof that it is ineffectual or that a non-regulated world would be better for the public.

As far as I'm concerned if "a fool and his money are easily parted" (as the old saying goes) and the fool happens to be rich, why interfere with the process? The SEC should be focused and have a proven track record of protecting the small investor before moving on to protect rich hedge fund investors. Plus, these investors are likely affluent enough to survive the destruction of part of their net worth. And if they had all of their money in one of these diseased baskets - Good !!! That's what they get for not properly allocating their capital.

I wonder if Refco's problems have a lot to do with naked shorting. Let's say just for discussion purposes that it does. Then could you even begin to imagine what could be lurking out there in these so called fair American capital markets? Of course Jeff doesn't know how to naked short and I am sure he is shocked that Refco blew up cause the SEC is so on top of the ball. It's funny that Jeff rips the SEC in this article and then acts like naked shorting could never happen. Hypocritical isn't it?

Roberto-It's not that naked shorting can't happen - it's that it isn't really a problem. It doesn't effect the company's daily business operations at all. If a company is healthy and doing well, then all naked shorting is going to do is perhaps start a short squeeze later on. There is a lot more money on the long side than there is on the short.

Every company on the reg SHO list are companies with unproven track records, questionable business models and obscure futures. Exactly the types of companies you would expect to be heavily shorted.I don't understand why this is such a mystery.

JD: I agree with you that the SEC should be improved, but when our government is running huge deficits fighting a war in Iraq and fighting a war at home against taxes, there's not much the government can do to improve the lot of the SEC.

With that said, I think the hedge funds should stay unregulated by the SEC.

Here's why: as hedge funds continue to "blow up" due to nefarious management or shady trading and operational practices, other hedge funds will step into the void and present investors with an alternative of "openness" and honesty with their trading operations.

When those hedge funds successfully attract the capital of wealthy investors, only then will other hedge funds either "clean up their act" (sorry for the bad cliché) and get with the program of treating their clients with honesty and dignity for entrusting their money with them, or risk losing their investors to the hedge funds who treat their clients' money with respect.

Refco's thing is probably more like that of the Barings Brothers back in the mid 90s. I'm not sure, but Bennett seems to have pulled a Nick Leeson who fraudulently hid huge losses when he made some poor speculation after another. We all make mistakes, but Leeson and Bennett pulled some incredibly ballsy blunders.

Some of you may know what happened to Barings Brothers. It closed its doors, and ING bought it out. I heard ING got rid of the Barings name and assets earlier this year. Perhaps Refco will face a similar fate.

You've got to be kidding. I hope. For you to say that every company listed on the REG SHO list deserves to be there, either because they have "unproven track records, questionable business models and obscure futures," shows you have a certain class of myopia. Or maybe a brain cloud. Any company with whom you have a difference of opinion can, and perhaps should be, a short candidate for your portfolio. What does that have to do with the systemic Failures to Deliver on shares? One can be an insightful judgement that you don't think the company will do well. The other is making up counterfeit shares. One is a well respected stock market practice. The other is a crime. The fact that the crime is not at this time penalized by the system, (the Grandfather clause of REG SHO,) does not lessen or obviate the crime. If naked shorting drives down the price of a stock, (all selling does,) it doesn't matter whether or not you believe it. The REG SHO proves that it exists. If the DTCC lawyers admit that on an average basis, 80% of uncleared trades remain uncleared at the end of the day, while all parties concerned still get their commission, and their cuts of the sale, then what defenses does a company have to resist the 'death spiral' caused by unrestricted, and unrepentant naked short selling. Come on, you expect us to believe that you don't understand this?

From the beginning of Donaldson's SEC tenure, it has been my opinion that the SEC's initiative to regulate hedge funds was and is misguided. Having just recently left a hedge fund that was audited by the SEC, my opinion has hardened. It is a waste of time and money. It will not curtail nefarious practices by hedge fund managers either bent upon breaking the law or skirting it. Why do I say this? A little background: my former employer has been in business for less than a year and has less than $500M in assets. We registered with SEC immediately upon opening our doors and hence, were in the front queue to be audited. Lastly, I believe the business practices of the fund are of the highest quality. Nonetheless, the SEC spent 10 days in our offices poring over boiler plate legal documents, harassing our compliance/operating officer with demands for ever more paper, paging through past trades, and letters to clients. There were no substantive conversations with our prime broker, our methods of trading/clearing, or an audit of our research files (which they ought to have paired with trades). The audit clearly valued process over substance. The entire procedure appeared to be an education for the young SEC auditors themselves. Aside from accreting to their knowledge (perhpas preparing them for another line of work?), I'm not sure how this kind of audit will make markets safer or more regular. It certainly won't prevent Bayou's, Wood River's, or Long Term Capital Management's. It smacked of the worst aspects of financial auditing in the late 1990's. Congratulations to the SEC for another policy triumph.

In reading the FT today, it became clear to me that Refco was, in fact, in the business of borrowing and lending securities.

Nonetheless, I stand by my point that the reason for the collapse had nothing to do with this business, a fact that is also very well documented.

What happened was a loss of confidence by investors due to discovery of internal self-dealing. That in and of itself does not appear to have actually weakened the company's financials, though it says a ton about their internal controls or lack thereof.

Allegations of anything else at this point are completely unsubstantiated.

"Those hedge funds in which people stole everything and then went into hiding? The guys who everyone else figured out weeks or months ago will likely go to jail? They are bad guys. (See how impartial and brave a crusader I am?) But the authorities should look no further at anyone else in our industry."

Thanks for keeping us up to speed on what the CEO of an internet-based company whose "best CIO in America" just took a leave of absence during an as-yet unfinished major technology upgrade at the start of the holiday sales season is doing with his time.

Refco appears to be a company with a solid business and a few crooked people. That's why I say the problem was incidental to the any particular business unit.

That's not to say that a crooked CEO is a good thing. But a crooked CEO running a good business is something that can be overcome by removing the CEO. Compare that to a crooked CEO running a sham business -- like Bernie Ebbers -- at Worldcom, and you get a well-deserved bankruptcy.

So I'll repeat my assertion: There is no evidence that the Refco mess has anything to do with illegal activities in their stock loan business, and no evidence that such activities took place. That's not to say that none will be revealed, but so far all indications are that the problems were not in the business's day-to-day operations, but rather were confined to a small group in the executive suite.

And yes, I agree that ultimately trustworthiness is all you have in that business. Which still doesn't tie this company to any naked shorting conspiracy.

Every quarter they create thus ruse to hide the debt. every quarter they do so it costs them $90,000 in interest payments to Liberty. It has been well stated that this debt dates back to 1998. That figures on a cost to hide of over $1 Million. Would it not have been cheaper to slowly write teh debt off as opposed to carrying an "expense" every quarter of $90K?

Nobody knows exactly what the "bad debt" is all about but what is more concerning is - NOBODY is asking. Soon they all will as this "bad debt" has now resulted in tens of billions in investor losses when you calculate the trickle down impacts.

refco investors have lost 42 billion on their own. Add in the underwriters, the CME, etc...and those that invested there and the impacts are wide-ranging.

BTW...Wanna bet that next week or so RFX will be on the threshold list? The industry raiding on a bad thing and using stocks that cannot settle - what say you then?

With the stock under a trading halt, the SEC and NYSE should have no problem determining who it was that was trading shares that did not exist if RFX becomes listed. It cannot be specialists as orderly market in a sell off is not to sell more.

I think the regulators will have an easy time figuring out who was getting preferential treatment and raiding into the stock taking advantage of the market conditions. I certainly hope certain hedge funds are not caught with their hands in the cookiejar.

Jeff,Must apologize if I was veering off on an angle without explanation. 3 sources now claim that a big part of the REFCO problem was unsettled, undelivered stock transactions, hence, the naked shorting comment. I thought it was relevant to this blog. Secondly, since it was Morgan Stanley that has been named as the broker unable to deliver either Patrick Byrne's 25000 share purchase for 50 days, and his father's 200,000 share purchase as of this date, I thought that was also relevant.I only mentioned TROWEPRICE, as that's the broker my Dad uses for his portfolio work.My response to Mr. Fischer's comment is self explanatory, I think.Further, just because neither you nor I know how to naked short, that doesn't mean it can't be, or isn't, done.

You must understand. Jeff has an agenda and he is freee to move these blogs along based on personal agenda.

Jeff's constant "denial' is troubling based on the evidence we are presented daily regarding the normal settlement of trades. if you notice Jeff frequently blames the FTD's in overstock as "failed trades' yet the buyers still own the shares and the sellers ahve had a volume of over 75 times shares purchased to come up with legit shares.

Refco is about to blow as is naked shorting. Hedge Funds are about to get caught in a political trap they will never dig out of. you trade on shares that do not exist - for preferentiakl treatmnt is ILLEGAL and agisnt the basic principles of this market and this country. Politicians are like New england weather, they change rather frequently! When it is their neck vs. a hedge Fund contributor take a guess where they go.

The problem with the SEC, Jeff, is that before any enforcement action can proceed (civil charges), the enforcement lawyers must present their case before all 5 SEC Commissioners to get "approval."

The SEC knew there were problems with Refco as early as last summer. How do I know? I testified before 3 SEC attorneys about Reg SHO and naked short selling (without a Wells Notice). At the time I didn't have the information they wanted on Rhino Advisors and Sedona.

I did have some info on related matters which apparently they did not have (former Prudential Securities execs who had unsavory dealings with convicted felons at some Canadian bucket shop/boiler room operation which specialized in PIPE deals and penny stock pump and dump scams).

My question to them (and yes I did ask their most proactive Commissioner as well as Linda Thomsen and several of her staff) is why permit Refco to go public in August if they (the SEC) slapped a Wells Notice on their COO in May of 2005? Why would anyone in their right mind permit a firm whose COO was under scrutiny for federal securities laws violations go public in this sector?

Listed below is public info (Matt Goldstein's work) on the SEC's probe into Refco's COO:

http://www.thestreet.com/pf/markets/matthewgoldstein/10223924.html

http://www.thestreet.com/pf/markets/matthewgoldstein/10238911.html

I think the SEC dropped the ball on this Refco mess for several reasons:

Cutler announced his intent to go back to private practice in May or June of this year. The lead attorney investigating Refco's connection to Rhino was promoted to another position in Philly (he formerly was in DC). Bill Donaldson and Harvey Goldschmid announced their decision to leave also (creating a situation with 2 lame duck Commissioners and 1 other---the good one, up for renomination). Maybe the enforcement attorneys didn't have a solid enough case to present this past summer in order to get approval to proceed with civil charges.

It's my opinion that too much internal turnover/upheaval is what resulted in them dropping the ball on Refco. Let's hope it wasn't the NYSE and Refco's underwriters leaning on them to look the other way (something I considered but dismissed as even I am not that cynical).

That being said, I am not an apologist for the SEC. I urge you and others here who do have concerns about how they operate to help them improve. They are open to constructive criticism. They know they have issues and are trying very hard to be more proactive.

Chris Cox is a rookie and still is not up to speed as to what's going on at the SEC. Annette Nazareth came out of SEC market reg and is responsible (to some extent) for the grandfathering effect of the current Reg SHO.

I never said any companies "deserved" to be there, or that I had "difference of opinion" with any of the companies (I don't even know what you mean by that.) My point was, most of the companies on REG SHO are volatile, smaller companies that you might expect to be heavily shorted.

You sound very much like Patrick, where there is some organized scam to target companies and drive down their share price.

You ask "then what defenses does a company have to resist the 'death spiral' caused by unrestricted, and unrepentant naked short selling"

It's called a EFFICIENT MARKET. If short sellers batter the share price down to where it represents a more attractive investment, other buyers will step in. This entire concept seems very elusive to all of you naked short conspiracy theorists. Maybe you could write the addendum to the Efficient Market Theory dealing with naked shorting.

OK then. It's good to see you acknowledge the difference between Naked Shorting, (that's when the shares are never delivered, 'cause they've never been borrowed,) and regular shorting.

If "every" company on the SHO list is "small," and "volatile," where does that put USG?

And, what I meant by 'difference of opinion," is that all companies think that their share prices should go up. Your comments indicate that you think in some instances their share prices should go down. If you think the prices should go down, you short. If you want the share prices to go down, but there are no shares to short, you should be out of luck. If you get some broker to help you short stock that has no shares to borrow, you should both go to jail. I don't know how to naked short, nor would I want to. But, if I can't do it, nobody should be able to. It's illegal. The SHO lists proves that it does, however, happen, and there's nothing you can say to make it not be true.

I never said naked shorting doesn't exist, or that it couldn't happen. I said that I just don't believe it's really a problem for the companies themselves. Knowing how competitive efficient markets with large numbers of participants work, it's highly implausable that naked shorting could have any meaningful lasting depressive effect in the share price of a company.

I'm sorry. I should have used the word "most" instead of "every" to describe the companies on the REG SHO list. Did you have to scroll all the way down to the U's to find a counter example? And actually, if you look back past the 5 year chart, you'll see that USG had a very checkered past.

Without picking apart your last paragraph line by line, it seems pretty apparent that you have a limited understanding of how capital markets function. From your own comments, you don't know how naked shorting works.

Most often, when a stock is trending downward for an extended period of time, it's from people selling the shares, not shorting - naked or otherwise - and it usually accompanies a deterioration in the company's fundamentals. That's all. I will admit though, it's not nearly as sexy as naked shorting and Sith lords.

Look at all the money Wallstreet gives BOTH political parties and you understand why a REFCO can go public only to find out a few short months later its a scam. This blue color worker thinks wallstreet is broken and Washington REFUSES to allow someone to fix it....

Wallstreet , CNBC and the Gov should stop everything and have the public tune into the OSTK conference call ...they should require the public to review the OSTK "case file" ....But that might fix something...sorry , i will go back to my fork lift..

"rvac106": no need to apologize. I understand now where you were going.

I have to correct one misstatement, however.

You said I claimed not know how to naked short. That is wrong. Everybody knows how to naked short--even Patrick Byrne. You sell a stock short without borrowing it.

What I have said all along, however--ever since Patrick allowed Phil Saunders/dba Bob O'Brien onto his January conference call and they pretended not to know each other while Saunders did his ridiculous Conspiracy Theory involving German share listings and such--is that I don't know how to do it in a legitimate hedge fund, of the type most hedge funds operate.

You need a bad trader, a bad Prime Broker, and a bad accountant to do it. The Bayou Capital guys are prime examples of how a scam requires a several layers of bad guys.

But scams--and naked shorting--can be done.

Merely because it can be done, however, does not mean it is common among hedge funds.

After all, some corporate executives conduct illegal activities--say, stock-parking or leaking inside information, or even smoking pot on the corporate jet--but that doesn't mean it is common among corporate executives.

Well did Patrick serve the amended lawsuit ? I don't know whats going on here but my gut says we are leading up to a interesting conference call. Maybe something like Patrick claiming he needs to leave oSTK to fight the Sith Lord . Something to divert attention from the business ....but we should all know by now " follow the money"

The failure of Refco had absolutely nothing to do with naked short sales.

Refco has two regulated subsidiaries. Refco LLC is the futures subsidiary, regulated by the CFTC. No problems there. Refco Securities LLC is brokerage subsidiary, regulated by the SEC. If there was some issue with delivery fails it would be there. But there weren't any problems with this sub, either. The issue was in the unregulated subsidiary, Refco Capital Markets. The primary business there is derivatives.

If the whole "Naked Short Sales" gang wants to debate the immense derivative exposure of Wall Street and the banking system in general, at least they'd have an argument. And Refco might be a case in point. Of course, since OSTK and NFI have nothing to do with derivatives, they'd have to come up with another reason why the stocks are down. So instead the straw man of naked shorts sales comes up in connection with Refco. And it sounds pretty darn silly.

dndnupup--First of all, none of what you say has anything to do with Refco, which was what my comment concerned. My basic point stands--Refco's failure has nothing to do with naked short sales, and verbosity doesn't make it any more so.

Second, if what I read from Byrne is accurate, Morgan Stanley didn't fail to deliver the shares, it was Byrne's broker, whoever that was. Apparently the broker blamed Morgan Stanley, and Byrne chose to believe that. When a broker makes a mistake, they always try and blame another broker. Whether or not the blame is accurate is impossible to prove. That is why Byrne should have forced a buy in if he really just wanted his shares. He didn't, which tells me that he was more concerned with the PR than the shares. Maybe it was due to naked short sales, maybe it wasn't. All we know is that Byrne's broker made a mistake.

And again, none of that has anything to do with Refco. If you could help me understand where it does then maybe that opinion would hold more weight. If you can show me anywhere that there's a connection, please do. The affadavits from the OSTK lawsuit have nothing to do with naked short sales, either. And the more you guys rant about irrelevant things the more I'm convinced that you don't have any ground to stand on.

NEW YORK (Reuters Health) - Pathological liars may have structural abnormalities in their brains, a new study suggests.

Dr. Adrian Raine and Yaling Yang of the University of Southern California, Los Angeles, and colleagues found that individuals who habitually lied and cheated had less gray matter and more white matter in their prefrontal cortex than normal people. They report their findings in the British Journal of Psychiatry.

Past studies have found that the prefrontal cortex shows heightened activity when normal people lie, and it is believed to be involved in both learning moral behavior and feeling remorse.

Because gray matter consists of brain cells, while white matter forms the "wiring" or connections between these cells, pathological liars may have more capacity to lie and fewer moral restraints, the authors suggest. "They've got the equipment to lie, and they don't have the disinhibition that the rest of us have in telling the big whoppers," Raine said in a press release accompanying the study.

The researchers used a series of psychological tests and interviews in a group of volunteers to identify 12 pathological liars, 16 people with antisocial personality disorder but no history of lying, and 21 normal people. They then examined the brains of all study participants using magnetic resonance imaging.

Liars had 26 percent more white matter in their prefrontal cortex than people with antisocial personality disorder, and 22 percent more than normal people. But they had 14 percent less gray matter than normal individuals.

Interestingly, the researchers note, autistic people -- who are known to have difficulty lying -- show a shift in gray-to-white matter ratio opposite to that seen among liars in the current study. "Although autism is a complex condition and cannot be taken as a model for lying, these results on autistic children, combined with the prior fMRI findings on lying in normal controls, converge with current findings on adult liars suggesting that the prefrontal cortex is centrally involved in the capacity to lie," the authors write.

Also, they note, while small children aren't good liars, by the age of 10 -- by which time a burst in white matter volume has occurred -- they become much more proficient in telling falsehoods.

While the findings have no practical implications at present, if confirmed they could be useful in clinical diagnoses of whether a person is pretending to be sick; in criminal justice settings, by helping police determine if a suspect is lying; and in pre-employment screening, the authors suggest.

"padawancowboy": I read that article and, like you, found it fascinating--if the findings could be harnessed in the right way, a diagnostic test could help investors avoid being misled by executives prone to "telling the big whoppers," as Dr. Raine says.

And the Wall Street Journal reports that Refco faces millions in fines as well as civil and possible criminal charges related to it participation in the apparently illegal stock shorting practices by some of its clients, a practice known as "naked shorting."

Meanwhile the Journal reports the firm faces problems as part of various probes into the practice of known as "naked shorting." Generally someone who shorts stocks borrows shares, then sells them, in the hopes that the stock will decline in price and they'll be able to buy shares to replace the borrowed stock, pocketing the difference as a profit.

The Journal says that in the case of so-called naked shorting, investors sells shares they don't own or haven't borrowed, knowing they have several days to deliver the shares. The practice is generally illegal.

The Journal reports that Refco earlier this year disclosed that the SEC had notified it of plans to file an enforcement action against the company's Refco Securities unit for securities-law violations in connection with the shorting of Sedona stock. The notice received little attention at that time, though.

The firm's disclosure said that the SEC officials have sought information related to, among other things, two former Refco brokers who handled the account of stock-trading client, a Panamanian corporation called Amro International, which engaged in short sales of Sedona stock.

Dunno, how 'zat work? Do they have to buy in? Will that affect the price of the shares? Were any of the shorts in NFI? OSTK? Perhaps an Autism Drug Manufacturing company, who's being shorted out of existence?